Special considerations for financial instruments in business combinations

Financial instruments in business combinations

Business combinations oftentimes have quite an impact on the accounting key figures provided for public consumption.


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The cooperation between two companies can take on various forms. Often, one-off collaborations are regulated with individual contracts or joint ventures, while in-depth and long-term collaborations are set up with the help of equity investments or even a business combination. Depending on the size of the acquired company, such business combinations oftentimes have quite an impact on the accounting key figures provided for public consumption. In general, this means the joint presentation of operative business activities, as well as other business transactions. While the operational business activity is often the economic reason for the merger, the important impact on the consolidated financial statements will often appear somewhere completely different.

Both IFRS 9, which regulates the recognition and valuation of financial instruments, and IFRS 13, which regulates the valuation of fair value, have relevant interactions with IFRS 3 and the balance sheet presentation in view of the respective subsequent measurement of the acquired business transaction. Numerous projects show that the major drivers for KPIs resulting from business combinations arise from the recognition and valuation of financial instruments. Relevant expenditures often only appear in the periods after the merger, i.e. precisely when the economic success of this transaction should be presented to the capital market. An unexpected result, especially unplanned expenditures, may have to be explained separately. 

In this regard, there are above all two aspects which may affect results considerably. On the one hand, the impairment regulations of IFRS 9 must be applied to all financial instruments not recognized at fair value through profit and loss in the first post-merger measurement. On the other hand, a revaluation of acquired debts generally leads to significant adjustments when calculating goodwill. Goodwill that is too high bears the risk of future impairments (as defined in IAS 36). Beyond that, there are other aspects related to financial instruments and business combinations that need to be considered.

The impairment rules (as defined in IFRS 9)

Impairment rules define that one of the companies combined must synchronize its value adjustment process with the process of the other business. Groups should have consistent processes to determine value adjustments of similar financial instruments, not only to fulfill the requirement of consistency but also for purely practical reasons, i.e. not to make the Notes interminable. 

Furthermore, the capturing of value adjustment must always consider the following important idiosyncrasy: Despite the fact that financial assets must initially be valued at fair value, the company has to calculate an impairment (in accordance with IFRS 9) for these same financial statements in the final accounts published immediately after the merger as the general value adjustment principles apply to these financial instruments (IFRS 9.5.5). This means that – despite the fact that the fair value (IFRS 13) includes all of the value-determining factors and thus also the credit risk – a value adjustment must be subsequently measured for these financial instruments and subsequently recognized as an expense. The balance-sheet approach of initially recognizing and then subsequently valuing these acquired financial instruments therefore means that the value adjustment is entered double. This is applicable for financial debt instruments that are not already recognized at fair value through profit & loss or included in an individual impairment . The expenditure that results from this may be significant as these instruments (comparable to the transition from IAS 39 to IFRS 9) are for the first time fully encumbered with an impairment. This effect typically arises for both traditional financial instruments used by Treasury as well as for asset exposures or trade accounts receivable.

Not to be ignored are the rules applicable to financial debt instruments encumbered within an individual impairment allowance. While it is not necessary to calculate and capture a “double” impairment for these instruments, they are financial instruments that have already been acquired impaired. IFRS 9 has a special value adjustment method for such instruments (POCI as defined in IFRS et seqq.), which was not relevant for most industrial companies in the context of the initial implementation of IFRS 9. When using the POCI approach, the fair value recognized for the initial valuation is transferred to the expected cash flows through profit or loss using the the effective interest rate method. If the acquired company carries relevant financial instruments in its individual impairment allowance, this approach may require considerable implementing efforts. At a minimum, however, these instruments must be disclosed separately in the Notes (IFRS 7.35), as the gross carrying values of the receivables with individual impairment allowance can generally not be considered to be immaterial. Combining these with the acquiring company’s receivables with a individual impairment allowance should therefore be avoided.

Both topics also require prudence in subsequent valuations. After the business combination, these units will also cause new financial debt, which will have to be captured in the balance sheet without the special effects described above. These new instruments include neither the value adjustments counted “double” nor may new individual impairment allowance be valued using the separate (POCI) approach. Simultaneously, the receivables acquired in the course of the business combination will remain on the group’s balance sheet for a while and must be disclosed separately.

Goodwill as a risk for future goodwill impairment (as defined in IAS 36)

Goodwill is calculated at the time of acquisition. This procedure has several special features which are presented individually in IFRS 3. In summary, to calculate the goodwill, the sales price is compared to the net asset value of the acquired company. In doing so, the original loans payable are valued at fair value. The large nominal amounts usually cause significant reconciliation effects. Ideally, prices quoted on active markets should be used when valuing original financial liabilities; however, these are often not available. Normally, the original financial liability must be valued using a net present value method. The net present value method discounts the expected cash flows of the financial liability using a discount rate adjusted for credit risk. Upon publication of IFRS 13, IASB decided that the view of the creditor should be applied for this valuation procedure. Once the market knows about the business combination, the creditors will take into account the foreseeably changed credit risk already at the time of the merger. A debt that so far had a “fair” interest-rate and where interest compensated above all for the credit risk, must then be assessed as a debt bearing a too high or a too low interest. The fair value of excess interest-bearing debts lies above their nominal value and in most cases, clearly above the current carrying value of the company to be acquired. This valuation effect has an immediate impact on goodwill because according to IFRS 3, the fair value is added to the newly combined company during the business combination. 

This revaluation of financial debts also has other special features. For instance, the acquired liabilities must be investigated for embedded derivatives that will have to be disclosed separately. Acquired debts often have special termination rights, which are often no longer closely associated with the basic contract because of the revaluation. IFRS 3’s special item for favorable interest rates arising from subsidized loans (IAS 20) is no longer applicable.

For all of these reasons, it is a good idea to get support in accounting questions for a business acquisition or merger in order to avoid any unpleasant surprises later on.

Source: KPMG Corporate Treasury News, Edition 92, June 2019

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